Comparison of accumulating ETFs and distributing ETFs

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Ambox globe content.svg This article contains details specific to non-US investors. It does not apply to United States (US) investors, or to US citizens and US permanent residents (green card holders) living outside the US.

Non-US investors may have a choice between accumulating ETF and distributing ETF share classes. This page outlines the difference between the two types of ETF share class, and shows that apart from possible differences caused by local taxation of the two types, the results obtained from both will be the same.

Introduction

Under US fund regulations, a US domiciled mutual fund or ETF (exchange-traded fund) must distribute at least 90% of its income to shareholders[1].

Non-US domiciled funds and ETFs do not have the same restriction. This allows them to create different classes of ETF shares. Those that pay dividends periodically to investors are known as distributing ETFs. Others can elect to retain the income from the assets they hold, and use it to invest in more of those assets automatically within the ETF itself. These are known as accumulating ETFs.

Investors in some countries may be able to achieve a slight tax advantage by preferring one class of ETF shares over another, but this depends on local country tax law. However, excluding any local tax advantages and trading costs, where two ETFs contain the exact same assets, but one is distributing and the other accumulating, the long-term performance of the two will be the same.

ETF distributions

A US domiciled fund or ETF will periodically pay out dividend distributions, and also may on occasion pay out capital gains distributions, both short-term and long-term. It does this to meet US regulations for investment companies. These are the funds and ETFs generally discussed by and available to US investors.

Non-US domiciled funds and ETFs usually do not pay out any capital gains distributions, allowing holders to 'roll up' all capital gains until fund units or shares are eventually sold. They then fall into two basic types:

  • Funds that pay out dividend distributions are distributing funds or ETFs.
  • Funds that retain dividend distributions and reinvest them internally are accumulating funds or ETFs.

At the time of writing, the majority of non-US domiciled ETFs are distributing, but over time more accumulating types are coming onto the market. For efficiency reasons, ETF issuers will find accumulating ETFs particularly attractive where the dividend income generated inside the ETF is small relative to its net asset value (NAV).

Effect of distributions on fund net asset value (NAV)

When a distributing fund or ETF pays a distribution, its net asset value will drop by the per share amount of the distribution. However, ignoring taxes the investor's position has not changed, because they will receive cash to the value of the drop in their ETF holding's valuation.

In comparison, an accumulating fund or ETF pays no distribution, so its net asset value does not drop periodically to compensate for the distributions being paid out. Instead, the fund or ETF itself uses the income generated by the assets in the fund to buy more of those assets, so that its NAV remains constant.

Comparing distributing and accumulating ETF outcomes

The choice of which class of ETF shares to use, distributing or accumulating, makes no difference to the long-term results generated by the fund. There are some cash flow and possible tax effects, but for two ETFs containing the exact same assets, one distributing and the other accumulating, the investment returns are the same.

Here is an example. Suppose two ETFs, one named DIST that is distributing, and one named ACCM that is accumulating. Both are launched on the same day with an initial NAV of $1, and both contain the exact same assets. The assets return 10% annually, 7% as capital gains and 3% as dividends. ACCM reinvests the 3% dividend internally into more of the same assets that it already holds, DIST pays this 3% to investors as a dividend distribution.

The following table shows the relative results of two investors, one who buys $10,000 of DIST and the other who buys $10,000 of ACCM at launch. The investor holding DIST reinvests their entire annual dividend distribution into DIST shares as they receive it, and the investor holding ACCM does nothing. The table ignores both tax and trading costs, and assumes no capital gains or other non-dividend distributions.

Comparison of accumulating and distributing ETF investor outcomes
Accumulating ETF investor Distributing ETF investor
Year ACCM net asset value Shares held Holding balance DIST net asset value Shares held Holding balance Cash residue
1 $1.0000 10000 $10,000.00 $1.0000 10000 $10,000.00 $0.00
2 $1.1000 10000 $11,000.00 $1.0700 10280 $10,999.60 $0.40
3 $1.2100 10000 $12,100.00 $1.1449 10568 $12,099.30 $0.66
4 $1.3310 10000 $13,310.00 $1.2250 10864 $13,308.87 $1.02
5 $1.4641 10000 $14,641.00 $1.3108 11169 $14,640.28 $0.50
6 $1.6105 10000 $16,105.10 $1.4026 11482 $16,104.10 $0.71
7 $1.7716 10000 $17,715.61 $1.5007 11804 $17,714.62 $0.59
8 $1.9487 10000 $19,487.17 $1.6058 12135 $19,486.16 $0.52
9 $2.1436 10000 $21,435.89 $1.7182 12475 $21,434.37 $0.92
10 $2.3579 10000 $23,579.48 $1.8385 12825 $23,578.24 $0.49

At the start of year 1, the both investors hold the same number of shares. At the end of the year, ACCM's net asset value is $1.10, because the ETF has internally reinvested the 3% dividend paid out by the stocks it holds into more of the same stocks. DIST's net asset value is $1.07. However, the investor holding DIST uses the 3% dividend distribution, $300, to purchase 280 more shares of DIST, and leaving them with $0.40 in residual cash because shares can only be purchased and held in whole numbers. The final position of both investors is the same.

At the end of year 2, the same happens. ACCM's net asset value rises to $1.21, DIST's to $1.1449, and the investor holding DIST uses the 3% dividend distribution, $329.99, to purchase 288 more shares of DIST at $1.1449/share, again leaving a tiny amount of residual cash but with the two investors otherwise in the same final position.

This repeats for years 3 to 10. In years 5, 7, 8 and 10, enough residual cash has accumulated to allow the investor holding DIST to buy one more share than is covered by the dividend paid out to them by the ETF.

At the end of ten years, although the investor holding DIST shares has suffered a tiny amount of cash drag because they cannot hold fractional ETF shares, the results are the same to within 99.997%. If fractional shares were available, the results would be exactly identical.

Although the example uses USD, this result is general to ETFs denominated or traded in any currency.

Effect of taxes

In some countries, investors do not have to pay income taxes on dividends that they do not receive. For investors in these countries, holding accumulating ETFs can provide a usable tax advantage over distributing ones. Even if there is a tax to pay later on the gains when the shares are sold, allowing the gains to 'roll up' with taxes deferred is a useful advantage.

In other countries, for example the UK, investors need to pay income tax annually on dividends, whether distributed or not, but these can then be subtracted from the gains on sale for capital gains tax calculations. Under this regime, the long term tax result from both distributing and accumulating funds and ETFs is identical. A cash flow problem can arise however, where tax has to be paid on a 'notional' dividend that has not actually been received.

Effect of trading charges

An investor that does not spend dividend income but instead reinvests it gains a modest but clear advantage from accumulating ETFs, because they avoid the trading cost of reinvesting dividends. Accumulating funds are ideal for long term buy and hold investments during the 'accumulation' phase of investing.

Conversely, an investor who is using ETFs to provide income might however face higher trading costs if they used accumulating ETFs instead of distributing ones. So for the 'decumulation' phase of investing, distributing ETFs may be the better option.

In practice, when moving from 'accumulation' to 'decumulation' it may be difficult to switch between the two types of ETF without incurring a significant capital gains tax liability, at least outside of tax-sheltered accounts. However, the effect of trading costs will generally be relatively low compared to the likely tax costs, so for most investors the tax effects will dominate.

Effect of large NAVs

A distributing ETF with a large NAV can result larger cash drag, due to inability of investors to hold fractional shares, particularly for relatively small purchases when reinvesting dividends. Using an equivalent accumulating ETF, if one is available, will help to mitigate this problem.

Comparing real distributing and accumulating ETFs

Comparing the performance of two real ETFs, one distributing and one accumulating, can be difficult in practice. The usual method is to add back any dividend distribution to the annual NAV gain. This is easy over a single year, but quickly becomes complicated to compute manually over a longer period.

If 'total return' charts or statistics are available for each ETF then this should provide the best comparison. However, even here some care is required. For example, a 'total return' chart might assume a particular tax rate on dividends that is at best an estimate and which will distort the comparison.

Overall though, it should be safe to assume that apart from differences in tracking error, two ETFs that track the exact same index, one distributing and the other accumulating, should produce broadly identical results, because the assets they hold will themselves produced broadly identical results. While local tax laws may change the final outcome, the fact that one ETF is accumulating and the other distributing does not affect the results returned by the ETF by the investor.

See also

References

  1. Investopedia, Regulated Investment Company (RIC), retrieved 8 May 2019.

External links